What Is a Collar?

What Is a Collar?

Let me explain what a collar is—it's an options strategy you can use to protect against big losses in a stock you own, but it also puts a limit on how much profit you can make. If you're feeling optimistic about a stock in the long run but concerned about short-term market ups and downs, this is something to consider. Essentially, you buy an out-of-the-money put option for protection and sell an out-of-the-money call option to bring in some income, which ideally covers the put's cost.

Key Takeaways

To sum it up quickly, a collar involves buying a put for downside protection and selling a call to hedge against large losses, though it restricts big upside gains. This combines a protective put with a covered call. Your best scenario is when the stock price hits the call's strike price exactly at expiration.

Understanding a Collar

You'd typically use a collar if you own a stock that's gone up in value since you bought it, and you're positive about its future but uncertain about the near term. To lock in those gains against a potential drop, implement the collar. The ideal result is the stock price matching the sold call's strike at expiration.

This strategy merges buying a put—like insurance against price falls, allowing you to sell at a set price if it drops—and selling a call, where you agree to sell at a higher price later and get paid upfront to help cover the put's cost.

Why This Might Not Be for You

This setup works if you're okay with no extra cost and fine capping profits if the stock surges beyond expectations. It's not ideal if you're extremely bullish on the stock. Note that a fence is a related strategy using three options for risk reversal.

Collar Break-Even Point and Profit or Loss

For your break-even in a collar, calculate based on net premiums. If it's a net debit, add the premium paid to the stock's purchase price. If a net credit, subtract the premium collected from the purchase price—that's where the stock needs to end for you to break even.

Your maximum profit comes from the call strike minus the stock purchase price, adjusted for net premiums. Maximum loss is the put strike minus the purchase price, again adjusted for premiums. These formulas apply whether it's a debit or credit setup.

Protective Collar Example

Suppose you own 100 shares of ABC stock, bought at $80, now trading at $87. To hedge against volatility, you buy a put with a $77 strike for $3 premium and sell a call with a $97 strike for $4.50 premium. This gives you a net credit of $1.50 per share, or $150 total.

Break-even would be $80 + $3 - $4.50 = $78.50. Maximum profit: $97 - $80 + $1.50 = $18.50 per share, or $1,850. Maximum loss: $77 - $80 + $1.50 = -$1.50 per share, or -$150.

Pros and Cons of a Collar Strategy

This appeals if you're protecting gains on an appreciated stock amid short-term concerns. It's good for moderate bullishness or neutrality, hedging downside without high costs. But if you're very bullish, it limits profits you might expect.

It's suitable for conservative investors prioritizing preservation over high returns, especially near goals. The big drawback is capping upside if the stock rises past the call strike, and the put cost is wasted if no drop occurs.

Why Is It Called a Collar?

It's called a collar because it sets a floor and ceiling on your stock position, like a collar restricting movement. The price is contained between the two strikes, offering protection but limiting gains.

When Is the Best Time to Use a Protective Collar?

Use it if you're moderately bullish but worried about downsides, especially after big gains or near financial goals. It works well in high volatility.

How Does a Collar Protect Against Losses?

The put sets a floor, limiting losses to the difference between put strike and original price, minus call premium. The call reduces costs but caps upside.

Can a Collar Strategy Be Modified Before Expiration?

Yes, you can adjust by buying back the call and selling the put if your outlook changes, but it might cost you and alter profitability. Monitor closely in volatile conditions.

The Bottom Line

In essence, a collar defends against downside while curbing upside, useful for stock positions or interest rate risks. You own the stock, buy a put, sell a call—collaring between strikes. If it drops, the put floors losses; if it rises, the call limits gains but provides income.